Monday, June 27, 2011

The Importance of Identifying the Underlying Causes of Long Term Bull and Bear Markets/Sold 170 NSSC at 2.93

With the robust stock market rally off the March 2009 low, the compound annualized return for an investment made in the S & P 500 on 1/1/1999 through 12/31/2010, was -.54%, with dividends reinvested, and adjusted for inflation. CAGR (compound annual growth rate). If I move the starting point to 1/1/2000, the annualized return falls to -2.07%. The S & P 500 has risen 97.1% off its March 2009 low. 

Historically, a long term stock bear market will have a series of strong cyclical bull and bear moves. Some of the strongest cyclical up moves in stock market history were recorded during long term secular bear markets, such as during the Great Depression and after the recent Near Depression.

Those strong up moves are viewed here at HQ as simply a reaction to the catastrophic phase of a long term secular bear market. A typical up cycle, within the context of a long secular bear market, would be between 1933 to 1937 occurring after the catastrophic 89.2% decline, October 1974 into early 1976, and the most recent spurt since March 2009, all occurring after the catastrophic phases of a long term bear market.   

When the reasons for that down cycle dissipate (or are recognized by the market as no longer dominant factors), and some powerful force develops to power a long term bull super cycle, then the long term bull cycle will finally emerge. It is never clear for an investor living through these cycles, except in hindsight of course, when one long term cycle has ended and the other has begun. 1974 or 1982: Start of Cyclical Bull in a Long Term Secular Bear Market or the Start of Secular Bull Market? (September 2009 Post); LONG TERM SECULAR BULL PATTERN 1950 TO 1966/ Long Term Secular Bear Pattern from The Great Depression (September 2009 Post).

The onset of a bear market cycle generally results from clearly excessive stock valuations that build up during the last phase of a long term bull cycle. 

Unfortunately, recognizing that demarcation line is key for an individual investor who is faced with a limited life cycle and a number of unique situational risks. So you have to do the best that you can given the unknowns and unknowables. Most individuals will need the robust returns provided during a long term secular bull market, in order to finance their needs during retirement. Living off the income generated by bonds now is not a long term option for many people.  

For most individuals, Professor Siegel's statistics about the relative performance of stocks over bonds since 1871 are not very helpful. Really, his argument is just absurd, except in a make believe world.

Most individuals are not able to save much money until later in life, and then retirement is looming when the individual will have to live off their investments, supplemented by social security payments and less frequently now a pension. For more retirees now, it is more of a question about living off their retirement savings in a 401 (k) or an IRA. So, the window for saving money is not that large before the individual has to start spending the savings.   

Sure, if I could all go back to the year of my birth, 1951, invest the money that I  have now in the S & P 500, I could see the wisdom of Professor Siegel's thesis. It would have helped tremendously that 1950 was the start of a long term bull cycle. I can not live in Siegel's make believe world, however, which would be ideal for trust fund babies or the spendthrift wealthy. Stocks for the Long Run: Jeremy J. Siegel: Books {I saw the same thesis presented in a recent Retirement Guide 2011 published by Fortune. That article,  which did have some big picture insights, spoiled it by quoting Siegel's thesis using data from 1802 to 2007, a grotesquely absurd time period for individuals facing a variety of situational risks, not to mention problems with the older data.}  

I recall in 1982 that many pundits believed then that the rally staring in August of that year was just another short cyclical up move in the long term bear cycle. That long cycle started in 1966 (see middle chart at More on 1982 or 1974).

An investor, buying the S & P 500 on 1/1/1966, would have suffered a compound annualized loss of 1.04%, with dividends reinvested and adjusted for inflation, as of 12/31/1982. That is a long time for an individual. The Roller Coaster Ride of the Long Term Secular Bear Market (May 2010 Post) To Professor Siegel: Time for a Re-Think Long Term Stock Risks and Situational Risk (March 2009 Post)  Siegel v. Arnott: Both Have Winning and Losing Arguments for Me in my Dynamic Asset Allocation (May 2009). Now if I had retired at 65 in 1966, needing my savings to pay expenses, how would I have fared under Siegel's stocks for the long run thesis? Most likely, I would have died poor, still waiting for that promise to bear fruit for me.   

The rally starting in August 1982 was not just another cyclical bull move in the context of a long term secular bear market. It was the start of a long term bull cycle.  I end that cycle earlier than others who use 2000 as the end date. I end that cycle in October 1997. Dating the Start of the Current Long Term Secular Bear Market (May 2010 Post) For that long term bull cycle, the mantra heard from financial advisers, "buys the dips, and hold for the long term" actually made sense, and at least made them appear to be knowledgeable. 

Of course, the future may be different from the past. The last two major up cycles (1950 to 1966/1982 to 1997) resulted in 14%+ CAGR with reinvested dividends in the S & P 500, adjusted for inflation, compared to an annualized loss of 1% to 1.5% on the same basis for the long term bear market.  Do I need to say more about the importance of identifying the nature of the long term cycle and its underlying dynamics?  

Each individual has to make up their own mind on this extremely important big picture view. 

I try to start my analysis by asking a very simple question. What is causing the long term bull or bear market?   The principal cause in my opinion for the 1966 to 1982 bear market was inflation. Once the Federal Reserve drove that bogeyman into the ground, the market had a good chance to start a long term bull move. By mid-1982, the more sound judgment, based on then existing evidence, was that the FED had successfully brought that problem under control. Hence, the better judgment then was the rally starting in 1982 was in fact the beginning phase of a new long term bull cycle.

Improvements in productivity, resulting from technological innovation, provided a prolonged fuel for the up move too. Those innovations centered around computers. 

Unfortunately, the up move was fueled also by the same factor that has caused the current long term bear market: TOO MUCH DEBT. Starting in 1985, without any rational doubt or question, both consumers and governments in the developed world started to spend ever increasing amounts of borrowed money.  The borrowings escalated at a rapid rate, as shown in graphs previously referenced many times in this blog. A typical set of charts are the following, showing increases in U.S. consumer debt:

U.S. Household Credit Debt Outstanding

U.S. Consumer DEBT to Disposable Income Ratio

Governments in developed countries have imitated their citizens desire to spend ever larger sums of borrowed money, in order to keep most of the population content. Spending borrowed money, in significantly increasing amounts over time, will create growth.

The  WSJ has an article in today's paper that pinpoints the original problem as too much debt. 10 Commandments for Frugal Living - TheStreet

Entitlements will vary by income class, but all segments receive a healthy dose.  Many in the middle class do not recognize the existence of entitlements for them. Many do exist including Medicare and certain tax breaks like the mortgage interest deduction. Medicare is primarily for the benefit of the middle class. The rich do not need either Social Security or Medicare. Most in that class would certainly prefer seeing those programs cut to avoid more taxes on them to pay for programs designed to benefit others, a desire finding a concrete manifestation in the budget recently approved by the House of Representatives with no Democrat votes. The poor have Medicaid, food stamps, etc. and so on. The rich have a large number of entitlements, usually found in the tax code.  Everybody is more or less content, not up in arms so to speak, as long as the nation can finance those entitlement with borrowed money. "Shared sacrifice" was gradually buried in the U.S., starting  after WWII.    

When looked at it in perspective, the seeds for the current bear market, caused by too much debt and leverage at all levels, were planted in the prior bull market, and fertilized excessively for many years. The spending of borrowed money contributed to the longevity of the prior bull market, by creating an illusion of growth that had to come to an end. Possibly, one could argue that household debt to disposable income could be increased to say 80 to 90%, provided it remained steady in that range, without creating a massive problem. That range would represent an increase  from the 60% to 70% ratio prevailing between 1960 to 1985, but may have not been problematic over the long term, especially when many could lower their debt payments with refinancings during periods of low interest rates. What ultimately was unsustainable was the relatively quick jump from 90% to 130% starting in 2000. It is helping now that a considerable amount of the mortgage debt has been refinanced at lower rates. 

Once I view the underlying problem as too much debt, and the cure being the need to cut spending and to save more,  then the question becomes whether that process is far enough along, and no longer an impediment to the creation of the long term bull cycle, similar to what was apparent in 1982 for inflation. Even if I can answer that query in the affirmative, which I can not do now when looking at the overall picture in developed countries, I would still need to find some driving force ready to power worldwide growth after the Age of Leverage. What Will Produce Growth after the Age of Leverage? (September 2009 Post); Underlying Cause of the Current Long Term Bear Market is Too Much Debt (June 2010 Post). 

Hopefully, I have identified the supporting fuel for the next long term bull market, the rapidly growing middle class consumers in emerging markets who are not yet loaded to the gills with debt, having just discovered in many cases the credit card. When that demand force becomes clearly more pronounced than the deleveraging force in developed markets, then I suspect the bull move can not only commence but also last.  I do not see that happening yet as the world teeters on one debt crisis after another, with several others still waiting in the wings.  It is impossible for me, for example, to use the word "sane" to describe our government's 1 trillion dollar plus budget deficits. A couple of trillion of borrowed funds for the GOP's war in IRAQ and the Democrat's "stimulus" package only added to the pre-existing government debt problems, while nothing was done to address the serious unfunded government liabilities running well into the trillions of dollars. I do not believe that members of either political tribe in the U.S. have yet come to terms with the necessary shared sacrifice that has to be sold to a public who are living under a variety of misconceptions and false information, fed in large part by the political parties themselves.    

I of course may be wrong, but I anticipate another cyclical down move in the market before the long term bull cycle will be able to form and to maintain a trajectory similar to what has been seen in the past. This next bull cycle will not be dependent to any significant degree on spending by the American consumer, who will become less important in the scheme of things every year. 

The GOP believed that Bush's tax cuts passed in 2003 would provide the conditions of economic nirvana to occur.  I have not mentioned that philosophy in the foregoing discussion, since those cuts were far more important in adding to the nation's existing problems rather than contributing meaningfully. Apparently, their plan now is to increase the tax breaks for the wealthy and hope for a better result. 

Far more powerful forces are at work. The GOP policy of tax cuts primary for the wealthy, who provide them funding in reciprocation, did manage to increase the government's deficits and dig the nation even deeper into the hole. However, the promised job creation did not materialize in the Bush years after those cuts, with the job creation record properly described as the worst in decades. A Lost Decade for Jobs & Income Growth Adjusted for Inflation and WSJ article Bush On Jobs: The Worst Track Record On Record And, I would add that most of the jobs created were soon lost, since they were connected in one way or the other with the housing bubble rather than to the stimulus impact tax cuts for the wealthy.
Any person, who lives in the world of dogma, would never see a financial crisis developing, or identify the causes of major business cycles.  In short, they are unable to process information in a non-biased manner and to arrive at informed judgments based on the most reliable information. A successful investor does not have the luxury of living in a make believe world, ruled by cliches, rigid beliefs, clearly erroneous or fabricated information, and a disinterest in actually learning from experience. The assertion, for example, of "buy and hold", is not a path to financial success for an investor facing significant situational risk with heavy stock exposure during a long term bear market in stocks.

Believing that tax cuts for the rich are the path to economic prosperity will cause an investor to ignore evidence of more powerful forces that will send the economy in a decidedly different direction.  The dogma of politicians, their TBs, and the supporting array of TV and radio personalities masquerading as journalists, particularly the faux blonde ones, have no place in the successful investor's universe. 

When the preponderance of evidence points in one direction, I will shift course and will do so fairly rapidly. Until that time, I remain in a trading mode applicable to an Unstable VIX Pattern within the context of a long term secular bear market.

If I see signs of more daylight, I will most likely start adding back stock ETFs that I recently sold, such as VEU and VV.  I would hope to see several of the following in the weeks and months ahead: a pick up in manufacturing after the recent slowdown, a vastly improved jobs picture, more evidence of responsible behavior by consumers dealing with excessive debt levels, adult behavior by U.S. politicians from both tribes which means compromises both on taxes and spending,  a slower inflation rate in emerging markets coupled with good GDP growth, a bottoming in housing prices, and no sovereign defaults in the EU. This article in Seeking Alpha highlights some of the known, existing risks to a market breakdown.

1. Sold 170 of Lottery Ticket NSSC at $2.93 (LOTTERY TICKET strategy) (see Disclaimer):  I bought 100 shares of NSSC at $1.8 and 70 at $2.25. This marks my second successful roundtrip in NSSC shares, with all purchases made in the LT category.  

LB'S rule on LT purchases limits the purchase amount to $300 plus any profits or distributions received from prior forays. Based on the profits from the previous sales, I could go as high as $514.75 in my next purchase, if any, without violating LB's exposure limit. 

1 comment:

  1. Excellent overview of cyclical market forces, processes and underlying causes!

    The main force keeping me in the stock market right now is the oft-mentioned "jihad against savers." I imagine that's true for many of us.